When a Small is a Tall: Finding Value in Small Caps

Step off Pilates, powerlifting is the new fitness trend du jour. It’s part of the social wave for women to be athletic and strong, instead of making ourselves as tiny as is humanly possible. But women aren’t the only ones who’ve taken a shine to the dead lift. Girls as young as 5 are hoisting barbells more than twice their weight, breaking world records, garnering legions of fans on social media (#KidsWhoPowerLift) and launching their own fitness brands along the way. This got me thinking about—what else—small and micro-cap stocks and their potential to “powerlift”— far in excess to their relatively puny size.

Earlier this year, I had the pleasure of attending the annual Ben Graham Centre’s Value Investing Conference in Toronto. One of the highlights was a presentation by Elizabeth Lily, founder and president of Crocus Hill Partners in St. Paul, Minnesota, which she founded in 2017. Lily, who has worked with Warren Buffett, and is, like him, a value investor, focuses on small and micro-cap companies based in the United States.

“Small caps have an above-average probability of swooning rather than soaring.”

Fair warning: Small and micro-cap investing is not for the faint-of-heart. Most of these companies— with capitalizations anywhere from $300-million to $2-billion—are ignored by portfolio managers and sell-side analysts. They are just too small and too volatile to be on their radar and few professional investors are willing to risk their careers by including too many of them in their portfolios. After all, small caps have an above-average probability of swooning rather than soaring. Still, for those like Lily who are willing to do their homework, the rewards are compelling.

“The companies that I buy are rarely covered by Wall Street analysts and they tend to have lower valuations which means that they’re likely to outperform over the long-term,” she says.

Unlike passively buying the market through an index fund or ETF, small cap investors need to follow the individual businesses more closely. Since many of these companies are off-the-radar, it’s a hurdle to get information on them. Hence, many investors won’t put in the time to visit the company, sift through their financial reports, interview management, customers and suppliers. This leaves the field open to those who will. And, it’s a far less crowded trade than buying Google or Procter and Gamble.

“There are a number of misconceptions about small cap stocks.”

There are a number of misconceptions about small cap stocks. For starters, many people believe that small companies carry a lot of debt. According to Lily, many small companies are well funded, and, like their mid-to-large size brethren, they pay dividends and buyback shares on a regular basis.

Another misconception is that small cap stocks can remain undervalued for a very long time. This may be true for some very small, family-owned enterprises but small companies that have activist investors or private equity investors are often under pressure to release value back to investors in a timely fashion by either rolling up competitors who are additive to the bottom line, or by being bought out.

According to Lily, here are 5 key points to keep in mind for small cap investors:

Rising interest rates and small caps: Because small companies are more leveraged to the business cycle, their revenues tend to increase during periods of rising inflation.

Volatility and small caps: Rapid stock price changes can scare investors away. Those who can take advantage of dramatic price swings can gain excess returns well above the benchmark.

Time horizon and small caps: As with most investing, having a longer-term time horizon is an edge for investors. Small caps can remain undervalued (and unloved) for long periods of time before their true value is released in a spectacular fashion.

Popularity and small caps: Because small companies live under-the-radar, investors need to be willing to take a contrarian position to the herd that rushes into the popular names that appear frequently in the business media. It’s good to remember that many successful companies operate outside of the limelight.

Catalysts and small caps: To surface value, small caps need a catalyst. This could be anything from a change of management, opening new business markets or products, industry consolidation, or even choosing to go private.

As always with investing, it’s important to know what you want to achieve financially and how much risk you’re comfortable with. Small caps, though appealing to some, are not for everyone. Ask yourself, “Is a small my tall?

Rita is the former editor-in-chief of ELLE Canada magazine. Rita is an investment and lifestyle writer and editor specializing in women and money. She is a Chartered Investment Manager from the Canadian Securities Institute.

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